Banks generate profits by attracting consumers to deposit their money for safekeeping in their vaults. They offer you a small enough rate that’s better than you stashing it under your mattress and then they take your money and lend it out to other consumers. CD investing is a way for you to get better rates of return on your parked money. The downsides are low rates and lack of access to your funds, unless you are willing to pay a small fine to gain early access.
Compounding interest is a concept that’s valid with most investments but even more so with CD investing. If you invest $100,000 in a CD at 2.5%, you aren’t just getting a 2.5% rate. After 10 years you would have a 28% increase in your asset value. Your account balance would be $128,000.
Another basic concept to remember is that when inflation goes up then CD interest rates go up as well. In recent history, CD rates have been abysmal because the US decided to keep inflation low. Now that the gov’t is allowing inflation to take its course, inflation is rising and so are CD rates.
It’s important to account for all the possible factors when investing in a CD:
- taxes (ordinary income tax rates)
- inflation (CD rates ~ inflation rates)
- fees (none except for early withdrawal penalties)
- liquidity (fairly liquid)
- risk (FDIC insured up to $250k per account)
What Is A CD?
A certificate of deposit (CD) is simply a savings account at a bank or a credit union. The main difference is that it requires a time-commitment on your part as opposed to a checking or savings account where you can withdraw your money at any time without any fees/penalties.
A CD is a savings account. They have been around long enough that investors have used it in order to grow their net worth.
CD’s have 2 components, 1) APY and 2) duration. These are just fancy words for 1) interest rate and 2) length of contract.
CD Interest Rate
The APY (annual percentage yield) is the interest that’s paid to you by the bank which issues the CD. This rate is guaranteed to you if it’s a fixed rat. There are variable rate CD’s and callable CD’s – try to stay away from these if you can.
Variable rate CD’s make very little sense for most healthcare professionals. The assumption is that if there is major inflation then your rate will go up accordingly. You’ll see below how this is something you can manage yourself, fairly easily.
CD Duration
How long are you willing to park your money in an account without touching it? The longer you are willing to let it sit, the higher your APY.
- 1 month?
- 6 months?
- 2 years?
- 3 years?
- 7 years?
The maturity date that you finally settle on will be listed on your CD statement. Once this time is reached you can either buy a new CD or cash it out.
The logic behind the bank wanting you to lock your money up with them is that they can depend on your money for a longer period of time and therefore lend out to more clients and take on bigger risks.
CD Fees & Tricks
The only fees associated with CD investments are early withdrawal penalties. Of course, you should always read the fine print because a bank (which is a private company) can choose to add whatever they want. You can find the details in the disclosure statement.
Auto renewal is used by some banks as a way to lock you back into the same CD. Most banks will be very diligent about notifying you that your CD’s maturity date is coming up and inquire as to what you want to do. Some may not be as vigilant, so mark your calendars.
Early Withdrawal Penalty
It varies from bank to bank but most will charge you somewhere between 3-months to 12-months worth of interest, depending on the duration of your CD.
If you invested in a 5-year CD and took your money out after 3 years then expect to pay 12 months worth of interest penalties.
How does that work? If your 5-year CD had an interest rate of 2.5% then 12 months of interest penalties would be 2.5%. 6 months of interest penalty would be (2.5%/6). If you invested $100,000 then 6 months of penalties would be $417 (0.025/6*100,000).
Liquidity
CD’s are fairly liquid but still not a good place for you to hold emergency money. You can request a withdrawal from your CD and can expect it to show up in your account in under a week.
However, some banks will limit the number of withdrawals you can have in a CD account. Some will take longer to process a transfer. And of course there is a the early withdrawal penalty I mentioned above.
Risk level
Your CD is insured by the FDIC if it’s held at a bank or by NCUA if held at a credit union. Deposit accounts in banks are currently (2017) insured up to $250,000 per account holder.
If you are investing more than $250,000 then it’s advisable to hold multiple accounts in order to have each protected at $250,000. You should be laddering your CD’s anyways, so it works out well as you’ll see below.
Any risk with a CD would be from you not knowing the details of the term or your bank being shady and sneaking something in the disclosure statement. So, read it carefully, it’s often not that complicated of a document.
Inflation Risk
The main risk you’ll encounter is inflation risk. If you have $100,000 locked up for 5 years at 2.5% and consumer price index (inflation) goes up by 4-5% a year then you would have lost a bit of value.
A CD ladder can help you avoid locking up all your money in one fixed interest percentage. The advantage here is that when interest rates go up, CD rates go up as well.
a CD ladder
If you have $100,000 to invest then you take $20,000 and buy a 1-year, 2-year, 3-year, 4-year, and a 5-year CD. During the 5 years the economy might experience strong inflation and that’s okay because you only had $20,000 invested for 5 years.
After the 1st year one of your CD’s will mature and you can buy a CD at a higher rate. The CD is at a higher rate because the economy experienced strong inflation (↑inflation = ↑interest rates).
A CD ladder is something you need to keep track of yourself. It’s similar to the IRA ladder concept. There are apps and spreadsheets which help you maintain a ladder or you can dump the work on your kind financial adviser.
Current CD rates
CD investments are finally going up. They stayed low for a long time because the Fed (Federal Reserve Banking System) wanted to control inflation. The Fed is now allowing interest rates to go back up which will increase CPI (consumer price index) which is the cost we pay for common daily goods.
Here is a nerdy explanation of how the Fed does/doesn’t control inflation
As of 2017, there are several banks which offer CD interest rates above 2% for 5-year terms. You can check out Bankrate for a complete list but here are 5 banks:
- Ally Bank @ 2.25%
- Synchrony Bank @ 2.35%
- Goldman Sachs @ 2.4%
- Vanguard @ 2.3%
- Wells Fargo @ 0.95%
Historical CD rates
It’s interesting to see how CD rates have changed over the years. I was trying to find a unique angle but sadly it’s quite boring. The interest rates that CD offers are fairly consistent with inflation rates.
The above graph was done by Jim @ freeby50. It shows the relationship of CD rates (blue) to rates of inflation (pink). If you look closely enough then you’ll see that as soon as inflation rates go up, within a few months the rates of CD’s go up as well.
APY vs. APR
Sorry to do this to you guys but it’s helpful to know the difference. The APY (annual percentage yield) is a smidgen higher than the APR (annual percentage rate) which is why the APY is often advertised.
The APR is the actual percent offered to you annually on your CD balance. So if your APR is 2% then you will be offered 2% of your money every year – simple.
The APY takes into account compounding interest as well and has to do whether the interest is compounded daily, monthly, or annually. To keep it simple, APY will be a touch higher than APR but you should be more worried about APR when doing your nerdy calculation.
CD Investing Guarantees
The FDIC (Federal Deposit Insurance Corporation) is an independent branch of the government which protects you against the loss of your deposits in a bank, including your CD investing shenanigans.
To attract the big fish some banks will even get private insurance for amounts above $250,000. They will let you know if this is available to you. The first $250k would be covered by Uncle Sam and anything above that would be guaranteed by a private insurance company.
Taxation Of CD Income
CD income gets reported on a 1099-INT form. You will get taxed at your highest marginal tax bracket. The interest you received is considered unearned income. It will be taxed at both the federal as well as state levels. But you won’t owe taxes on it for medicare or social security.
If you earn $1,000 for the year and are in the 33% federal and 10% state brackets then you would only be left with $570.
Low Risk & Low Yield
With CD rates now at around 2.5% and climbing, should you switch into a CD? That depends on a lot of factors which you and your financial adviser should discuss.
- Is it better to be a in a bond or a CD?
- Should you move all your money into a CD because the stock market is due for a correction?
- How much of your portfolio should you keep in a CD?
In the past decade bonds on average have returned 4.5% and equities close to 9%. It’s hard to make a case that CD’s will offer you a higher return than stocks or bonds. But this is without taking a person’s risk tolerance into consideration.
I can see myself moving into CD’s at some point in the future because even though bonds and stocks offer higher returns, they also have more volatility. Maybe I’ll get tired of the ups and downs eventually. For now I welcome it.
Finally, if I don’t earn too much money then I won’t be taxed a much. That means that I would keep a lot more of interest returns.
Funky CD’s To Avoid
CD’s should be very straight-forward investment options. There is no need to make them complicated. There are callable CD’s, indexed CD’s, brokered CD’s, variable CD’s, and others which are too silly to mention.
Callable CD’s
Some CD’s will be callable. The wording in the contract will elude to this. Callable means that the bank that issues the CD can cancel the contract at any time and even change the rate. This is often the case in jumbo CD’s or longer term CD’s.
That said, if the interest rate is guaranteed and if the wording in the contract is consistent then you have nothing to worry about.
Right To Delay Withdrawals
Along the same lines, there is often a “right to delay withdrawals” clause in all CD contracts, and all bank accounts for that matter. This is to prevent customers making a run on their money and basically emptying out the bank.
Imagine an inflationary situation where everyone panics and forms a line at the bank wanting to withdraw their money. The banks (pretty much all) have the right to delay your right to withdraw your money for a few days until economic circumstances level out.
Brokered CD’s
These are CD’s where there is either a middle-person who sells you the CD or you buy it from a brokerage house instead of a bank. These are less favorable since the contract is often more complex.
The fine-print is critical in these CD’s because they can have all sorts of stipulations. Whenever there are complaints about CD’s to the SEC it’s often regarding brokered CD’s.